A few hours ago, the Senate did something truly amazing: it clobbered Wall Street and the banking industry, defying armies of overpaid lobbyists and passing genuine reforms for our run-amok financial system. Voting 59 to 39, the Senate passed Senator Chris Dodd’s sprawling bill to clamp down on the Wall Street excesses that nearly destroyed capitalism.

Here is my initial quick take in the Fiscal Times. But let me amplify a bit here. For all its compromises and omissions and special exceptions, this is a strong bill that will make life a lot less free-wheeling and lucrative for the big banks and, with a little perserverence, a lot safer for consumers and the economy as a whole. This is a victory for the good guys.

Go ahead and call me naive. Critics of the banks like Simon Johnson and James Kwak of Baseline Scenario will undoubtedly complain that the Senate capitulated to Wall Street because it didn’t try to break up the giant banks or properly clip their wings in areas like derivatives. And to some degree, Johnson and Kwak are right. One of the underlying causes of the crisis was that institutions like Goldman Sachs and Citigroup had become too big to fail, and many of them took reckless risks because they assumed on some level that the government would bail them out. Neither the Senate nor House bills would really reduce the number of too-big-to-fail institutions. Instead, they create a new “resolution” mechanism to shut them down in an orderly way if they do fail.

But before all the armchair pundits begin carping and tut-tutting, let us first appreciate how much the Senate bill actually does accomplish and how difficult it is to do anything at all when the full force of the financial industry is against you. Remember also that Dodd and the other Democrats had to contend with the hardball intransigence of the Republican Party, whose leaders tried to obstruct or gut just about every meaningful reform in the bill without proposing any of their own. This was not, repeat not, a philosphical disagreement between those who believe in the wisdom of government regulation and those who believe in the wisdom of free markets. However sincere Alabama’s Dick Shelby might be in his fear of overbearing government, this fight was about denying Demorats a “victory.” It was all straight from Mitch McConnell’s playbook for political success: just say no, no, a thousand times no — no matter how venal it makes you look.

Against that backdrop, it’s astonishing that the Senate bill actually became stronger as the process dragged on. The proposed consumer financial protection agency is stronger and I believe more independent than it would have been in the original Senate bill (more on that in a moment). The multi-trillion market in financial derivatives, which is almost unregulated right now, would for the most part have to be take place on exchanges or at least through clearinghouses — either of which require greater transparency and more pfront capital by the players. Banks, whose deposits are federally insured, would be prohibited from trading derivatives. And as an added surprise bonus, from none other that freshman Senator Al Franken, the bill includes a very smart reform to fix the corrupt busines model of credit-rating agencies.

My view is that it’s a nice start, but it’s important to keep in mind the limitations of the new rules and that more is needed. Yesterday, President Obama said of the bill:

There will be no more taxpayer-funded bailouts–period. If a large financial institution should ever fail, we will have the tools to wind it down without endangering the broader economy. And there will be new rules to prevent financial institutions from becoming “too big to fail” in the first place, so that we don’t have another AIG.

This simply isn’t true. There have always been taxpayer-funded bail-outs and there will continue to be taxpayer-funded bail-outs. While resolution authority will allow for some large, complex banks to be wound up in the event they become insolvent, there are legitimate questions over whether or how to apply it in cases where there are, for example, institutions with significant overseas components. Whether or not the bill would prevent the growth of new too-big-to-fail firms, it does almost nothing to shrink the many banks that already fall into that category. The New Republic‘s Noam Scheiber says there are some measures in the bill that will disadvantage big banks:

[T]he upshot of financial reform will have been to make it costlier to be a big bank relative to being a small or medium-sized bank—which is to say, it has effectively taxed bigness. That’s because the legislation imposes a handful of new mandates and regulations—like oversight by a soon-to-be-established consumer financial protection agency, as well as limits on fees for debit-card transactions—from which small and medium-sized banks are exempt. Other reforms—such as a bill Congress passed last year to limit hidden credit-card fees and make statements more transparent, and new restrictions on trading derivatives—would disproportionately dent profits at megabanks. These banks tend to have far bigger credit card operations, and are the only bona fide derivatives brokers around.

That’s something, I suppose, but not very much. The big key to bank profits is leverage, and too-big-to-fail banks are better able to lever up thanks to the implicit guarantee associated with their size. It will take tougher measures—meaningful leverage limits or a tax on bank liabilities—to chip away at too-big-to-fail status.

But perhaps tougher measures will be forthcoming. Wall Street didn’t anticipate a regulatory bill this strong, and Congress probably isn’t done tweaking financial rules yet. This bill would not have prevented the crisis that reached a head in 2008, but it does chip away at the factors which helped make that crisis possible. That’s a good start.

The gist of the administration’s attack on the too-big-to-fail (TBTF) problem is a provision known as “resolution authority.” Under the status quo, the government basically has two choices for dealing with a major financial firm on the brink of collapse: It can get out of the way and hope for the best, as it did to disastrous effect with Lehman Brothers. Or the Federal Reserve can float the company a massive loan, as in the case of AIG.

The idea behind resolution authority is to avoid these lousy choices. Under the new law, the government would be able seize the wobbly firm, fire its executives, and fund its operations until it could sell them off in pieces. The proceeds from these sales would pay the government back; whatever was left would go to bondholders, who would presumably suffer some losses. The shareholders—the people who own common stock—would get wiped out entirely. (If the proceeds weren’t enough to repay the government, it would recoup the rest by levying a fee on the industry.) This is basically a scaled up (and stretched out) version of the way the FDIC handles smaller-bank failures.

Long story short, resolution authority is unquestionably an improvement over the status quo. The biggest reason is that the prospect of losses for bondholders mitigates the most pernicious consequence of TBTF: moral hazard. That is, because people who lend money to megabanks assume the government will make them whole if the bank collapses, the lenders have little incentive to rein in excessive risk-taking by the bank’s managers. In fact, they actually encourage it by under-pricing their loans. The threat of being “resolved” by the government should change that calculus.

That’s how it’s supposed to work, in any case. In practice, there are a number of complications. For one thing, it’s not clear that bondholders actually will suffer losses in the end, at least not all or even most of them. The government isn’t likely to impose losses when it first takes over a failing megabank because doing so in the middle of a financial crisis—and you’re almost by definition in a crisis if a megabank is failing—risks accelerating the panic. (Investors might refuse to roll over their loans to other troubled companies for fear of suffering similar losses.) And if the government waits to impose losses until it’s done liquidating the company—a process that could stretch for years—the short-term bondholders will have long since taken their money and run.* So, at the very least, the people who lend short-term may count on being bailed out, which encourages companies to fund themselves with short-term debt, which is the least stable form of funding.

And there are other potential problems. First, the new law only extends to U.S. companies, while most megabanks have an international footing. It’s not clear what happens to the overseas operations of American companies while their U.S. assets are in receivership. In the case of AIG, the Fed loan kept the overseas affiliates solvent. But Congress is on the verge of explicitly preventing the Fed from extending such a loan in the future. The upshot could be chaos. For example, U.S. creditors might have to take big, upfront losses to make bondholders in overseas subsidiaries whole. That would worsen the panic at home for the reasons described above (and could eventually force Congress to step in with a bailout). All of which is to say that, while resolution authority is clearly a step in the right direction, it raises almost as many questions as it answers.

The good news is that resolution authority isn’t the only way to deal with the problem of too big to fail. Congress could simply break up the banks, for example. Alternatively, if you think of “bigness” as an externality—which is to say, something we get too much of because, like pollution or unhealthy eating, it imposes a social cost that the producer doesn’t entirely pay—then you can discourage it through taxation. (In economist-speak, this would force the banks to internalize the true social cost of their size.) One way to do this would have been to simply impose a tax on the biggest banks, which even conservative economists like Harvard’s Greg Mankiw support. Another way would be to impose stricter limits on leverage for the largest banks—that is, the amount of debt banks can take on relative to equity. Because banks earn more profits when they’re more leveraged (just like you make a larger profit, percentage-wise, when you flip a house on which you put down 5 percent versus 10 percent), this is similar to a tax on bigness.

Alas, none of these things is in the bill that Obama will soon sign. Congress voted down, and the administration opposed, an amendment by Senators Sherrod Brown and Ted Kaufman that would have shrunk some of the country’s biggest banks. Republicans then deployed a variety of underhanded tactics to block a vote on an amendment by Senators Carl Levin and Jeff Merkley that would have shut down the banks’ proprietary trading desks—which is to say, the trading they do for their own bottom line. (The administration and the congressional leadership supported the amendment, which was a relatively strict version of the so-called Volcker Rule.) And, while the government may soon assess a fee on banks to bridge the difference between the bailout money it paid out and the bailout money companies have returned, there won’t be a permanent tax on big banks.

Amazingly, and wonderfully, the Volcker Rule has made it through the Senate, and will surely not be opposed by the House, which never got an opportunity to vote on it. While Treasury might weaken or abolish Blanche Lincoln’s amendment forcing banks to spin off their swap desks, it now seems very likely that there will be some kind of legislation attempting to reduce the amount of speculation and gambling that goes on at regulated, too-big-to-fail institutions. While that kind of activity didn’t cause the financial crisis, I like the idea of it taking place at hedge funds and other institutions which tend to be less leveraged than banks and more capable of failing without massive systemic side-effects.

Of course, there are always things we’d like to see and which won’t make it into the final bill: the greatly-lamented part of the consumer protection agency which would force banks to offer plain-vanilla financial products is one, and Treasury will ensure that any limits on size or capital or leverage come out of Basel rather than out of Washington. (Me, I’d like to see a couple of basic rules or principles be put into US legislation, which would serve to backstop Basel.)

FinReg: what do I think? I think Ed Andrews has it right: not all it should have been, but better than seemed likely not long ago, thanks to a changed climate. Wall Street in general, and Goldman in particular, provided scandals at just the right time. Thank you, Lloyd Blankfein.

What’s missing? Hard leverage limits; size caps; not much in the way of restoring Glass-Steagall. If you think that too big to fail is the core problem, it’s disappointing; if you think that shadow banking is the core, as I do, not too bad.

Now, the truth is that we won’t know how good a reform this is until the next crisis (which is very different from health care, where there will be ample opportunities to learn from experience.) And the new system clearly won’t be robust to really bad leadership: once President Palin appoints Ron Paul as Treasury Secretary, all bets are off.

1) Wall Street should thank the White House. Had President Barack Obama prioritized bank reform over healthcare at the height of the crisis, the biggest players might have been broken up, hard caps placed on balance sheets, and banking and investing operations separated. More recently, the Securities and Exchange Commission’s lawsuit against Goldman Sachs in April helped re-energize advocates for such changes.

2) Nothing radical here. While the Senate and House bills still need to be blended, it’s safe to say the most radical ideas have fallen by the wayside. A “systemic risk council” of federal regulators will recommend new capital and leverage rules to the Federal Reserve, which will be the most influential bank regulator. The Federal Deposit Insurance Corporation will have the power to wind down any failing large, systemically interconnected institution.

In addition, large, complex financial firms will have to submit plans for their rapid and orderly shutdown should they go under. And for the first time the derivatives that are currently traded privately will mostly be forced to go through clearing houses and in some cases trade on exchanges. Bank lobbyists have defended their corner: it’s not the regulatory reign of terror their clients’ most vociferous critics wanted. But it’s hardly a “light touch” regime, either, and it does involve real changes. Caveat: This assumes the Blanche Lincoln provision on derivatives is softened or stripped in the conference committee.

3) Too Big To Fail is still a problem. As long as regulators and politicians have vast amounts of discretion, a financial crisis will make bailouts an irresistible temptation. The way around this is either breaking up the banks or creating hard, market-based triggers for either regulatory action or a resolution process. Neither is in the bill.

4) Wall Street’s has an enduring PR problem. Yes, big banks are unpopular. But it has gotten so bad that they may not be able to so easily counter their image issues with campaign cash. Getting Wall Street money now has a stigma attached to it like oil and tobacco money. Candidates like Meg Whitman in California and John Kasich are getting hammered for their Wall Street ties. The industry’s continued unpopularity will no doubt spawn further attempts to tax, regulate and restrict the sector.

5) Bernanke trimphant. The Federal Reserve has to be pretty satisfied. It did not lose its role as regulator; in fact, it’s been strengthened. And the central banks was also able to fend off attempts to make it more transparent. The downside: The GOP (see Rand Paul) has soured on the Fed in a big way, particularly at the grassroots. Further economic woes will lead to more calls to change its form and function.

Touching on a point I have madepreviously, however, I was struck by this Pethokoukis point:

Wall Street has an enduring PR problem. Yes, big banks are unpopular. But it has gotten so bad that they may not be able to so easily counter their image issues with campaign cash. Getting Wall Street money now has a stigma attached to it like oil and tobacco money. Candidates like Meg Whitman in California and John Kasich are getting hammered for their Wall Street ties. The industry’s continued unpopularity will no doubt spawn further attempts to tax, regulate and restrict the sector.

If the public stays this outraged for this lomg, then Pethokoukis is right. The political problems of finance are becoming so great that we could be talking about a shift in social norms with regard to what is considered “honorable” work.

[T]he wages of labour vary with… the honourableness or dishonourableness of the employment…. Honour makes a great part of the reward of all honourable professions. In point of pecuniary gain, all things considered, they are generally under-recompensed, as I shall endeavour to show by and by. Disgrace has the contrary effect. The trade of a butcher is a brutal and an odious business; but it is in most places more profitable than the greater part of common trades. The most detestable of all employments, that of public executioner, is, in proportion to the quantity of work done, better paid than any common trade whatever.

Question to readers: Will the social stigma against Big Finance persist or fade as the economy bounces back?

Commentary from the actual Wall Street blogs has been much more cynical. One popular blog post, which has been cross-posted at seekingalpha.com is entitled: “The Senate’s Faux Financial Reform Bill”. The anonymous author “George Washington” is not happy with the legislation since he does not think it is strict enough:

The Senate passed a financial “reform” bill Thursday by a 59-39 vote which won’t fix any of the core problems in the financial system, and won’t prevent the next financial crisis.

The bill doesn’t include the Volcker Rule (it wasn’t even debated), doesn’t break up or even substantially rein in the too big to fails, and doesn’t force transparency in the derivatives market.

After citing various Senators and academics who think the bill is too weak, Washington concludes:

The bill is all holes and no cheese.

Skepticism is the rule of the day on other posts. In a post from before the passing of the bill, Mike Konczal laments if anything is truly being achieved in the reform:

Instead of real reform, I worry we are going to get to wear a T-Shirt that says: ‘Taxpayers gave TARP, GSEs, TALF, AMLF, Maiden Lanes, ring fenced half a trillion dollars worth of debt in off-balance sheets, TLGP, TSLF, double-digit unemployment etc. and all we got was a consumer hotline to the basement of the Fed.’

Other blogs noted that the bill had passed, but provided little commentary of their own. The popular Wall Street tabloid Dealbreaker, simply included a short critical comment from the U.S. Chamber of Commerce.

While political journalists are understandably focused on the bill, Wall Street’s attitude seems to be more skeptical about the prospect. This might be because they would prefer to spend their energy focusing on where the next deal might be found, as opposed to commenting on legislation. This might explain why some investment blogs are focusing their time and energy on whether Australia’s banks are about to collapse.